The proper planning and formation of the FLP is critical, but there are certain events that must be avoided or you might risk invalidating the FLP. If the person or persons transferring assets into an FLP is in a terminally ill situation, the IRS can invalidate the FLP as it is seen as a way for the transferor to hide assets rather than protecting them.
It is equally important not to transfer all of one’s assets into an FLP. A person must maintain sufficient funds to handle everyday expenses. Failure to do this could cause adverse tax effects. Additionally, one cannot use FLP assets to pay personal expenses without following the terms of the FLP. This of course refers to distributions from the FLP to the owner. An owner cannot simply take money any time he or she decides to do so. There are specific circumstances in which distributions can be taken and they must be enumerated in the FLP agreement.
The FLP should not make inordinate distributions to an owner to pay for living expenses. Upon the death of the owner, the FLP should not pay for estate expense or estate taxes. That should be handled from personal funds of the owner or through a life insurance policy. Distributions to certain partners and not to others can spell tragedy for an FLP.
An FLP is a legal business entity and must be treated as such. The correct transfer of assets must be handled legally. If a house is being transferred, then a real estate deed must be drafted and filed with the proper government entity. The same holds true for a vehicle. The title and registration must be transferred through the Department of Motor Vehicles. Any other assets which have a title must be transferred in the same way. Other assets may be transferred by using a bill of sale stating the date, name of the transferor and what was transferred. A nominal purchase price should be made. In addition, the FLP must keep proper books and records as any business would do. If there is no change in the investment or business strategies of the FLP, the IRS can challenge the validity of the business.
No Active Involvement by Younger Family Members
When any of the limited partners are not actively involved in business decisions and not made aware of operations, then the FLP may be in jeopardy. All family members must be allowed to obtain advice from independent counsel or retain a valuation expert; otherwise the IRS may not allow tax benefits.